We are setting out below an important update regarding a new private ruling which was published on September 18, 2016, by the Israeli Tax Authority (the "Ruling"). The Ruling deals with a foreign tax credit with respect to an Israeli Relatives Trust, the settlor of which is a US tax resident that is classified as a Grantor Trust in the US.
A trust in which the settlor is a living foreign resident and at least one beneficiary is an Israeli resident, and in which the settlor and all the beneficiaries are relatives, is classified as a Relatives Trust. The income component of the distributions from such a trust to the Israeli beneficiaries is subject to tax at the rate of 30%-32%. Alternatively, such a trust can elect to pay 25%-27% tax on its current income, in which case, the distributions will be tax exempt.
The tax treaty between Israeli and the US does not provide for a solution in the case in which a trust is considered as both Israeli and US resident (i.e. a hybrid trust). In this case, it is not clear which country has the first bite on taxing the income and which country should provide the tax credit for the taxes that were paid in the other country. The treaty simply sends the parties to settle this matter in accordance with the competent authority’s procedure and does not provide for clear guidance in this regard. Accordingly, the ability of trusts that are subject to both the Israeli and the US tax systems to obtain credits, either in Israel or in the US, remains vague.
The importance of the Ruling is that for the first time, the Israel Tax Authority (“ITA”) sheds some light on its position regarding the country that should have the first bite on taxing the hybrid trusts' income.
2. The Ruling
The Ruling deals with a situation in which the settlor of the trust in question (the "Settlor" and the "Trust" respectively) is a US tax resident who was never an Israeli resident, while all the beneficiaries, who are the Settlor's grandchildren, are Israeli tax residents. Under US law, the Trust is classified as a Grantor Trust, requiring the Trust's income to be reported by the Settlor under his personal tax file. After the Settlor’s demise, the Trust's income will be reported by the trustees of the Trust.
The Ruling determines that as long as the Trust is classified as a Relatives Trust (generally as long as the settlor or his spouse are living and the settlor is a relative of all the beneficiaries), then the Trust shall be entitled to a foreign tax credit with respect to tax paid in the US on US-sourced income only (in this regard, tax that will be paid in the US with respect to non-US sourced income will not be credited). In addition, tax that will be paid in the US by the trustees of the Trust after the Settlor’s demise, will be credited in Israel under the same conditions, provided that the trust remains a Relatives Trust.
Moreover, the ruling also states that in the case the tax paid in the US with respect to US sourced income will be higher than the Trust's tax liability in Israel, then the Trust will be entitled to use the accumulated tax credit in the following years, provided that the Trust will still be classified as a Relatives Trust. When the Trust will lose the status of a Relatives Trust and become an Israeli resident trust, then it will no longer be entitled to use the carry over credits.
3. Difficulties with the Ruling and Open Questions
The main importance of the Ruling is that it enables Relatives Trusts, under certain conditions, to obtain a tax credit with respect to foreign tax paid by the settlor of the trust (and not directly by the trust itself).
Despite the above, the Ruling also raises certain difficulties, as well as open questions. For example:
- According to the Ruling, such a Relatives Trust will not be entitled to a foreign tax credit with respect to non-US sourced income. This means that the ITA believes that Israel should have the first bite with respect to non-US sourced income and as a result, the trust may be subject to double taxation with respect to non-US sourced income.
- According to the Ruling, such a trust will lose its accumulated foreign tax credit, if the classification of the trust is changed.
- It can be inferred from the Ruling that other types of trusts (for example, Israeli Residents Trusts) are not entitled to a foreign tax credit even on US sourced income. This result is extremely draconian and may subject a number of hybrid trusts to double taxation.
- It is not clear from the Ruling if a trust is entitled to a foreign tax credit in the case where it is not classified as a Grantor Trust in the US.